1. 1 Luo Ping China Banking Regulatory /Commission luoping@cbrc.gov.cm At APEC seminar in Shanghia, Dec 8, 2008 Basel II overview and its implications for emerging markets

2. 2 Table of content Basel II overview Agenda Implications for emerging markets

3. 3 The Organization of the New Accord

4. 4 Outline of the New Accord - Basic Structure

5. 5 >=>= 8% Tier 1 + Tier 2 + Tier 3 CRWA + 12.5 (MR) + 12.5 (OR) Operational Risk in the New Basel Capital Accord

6. 6 1 Risk weighting based on risk weights of sovereign in which the bank is incorporated, but one category less favourable. 2 Risk weighting based on the assessment of the individual bank. 3 Claims on banks of an original maturity of less than three months generally receive a weighting that is one category more favourable than the usual risk weight on the bank’s claim.0 Standardised Approach – Risk Weights

7. 7 Risk sensitivity of various approaches Comparison of Proposed Total Regulatory Capital Charges for Corporations Source for VaR Data: Breitling Study 0 5 10 15 20 25 30 AAAAA+AAAA-A+AA-BBB+BBBBBB-BB+BBBB-B+BB-CCC+CCC and worse (%) 99.97% VaR for unexpected losses Basel II’s standardised approach 1988 Basel Accord requirements for claims on corporations

8. 8 Elements of IRB Risk Components Obligor risk: probability of default (PD) Transaction risk:loss given default (LGD) Size of exposure:exposure at default (EAD) Obligor risk: probability of default (PD) Transaction risk:loss given default (LGD) Size of exposure:exposure at default (EAD) Key components Maturity Borrower size Maturity Borrower size Other important elements

9. 9 Risk Components: Drivers of Credit Risk Driver of Credit Risk Standardised Approach IRB Approach Obligor riskCredit assessment institutions Probability of Default (PD) Transaction riskCredit risk mitigation techniques Loss Given Default (LGD) Likely size of exposure Credit conversion factors Exposure at Default (EAD) MaturityLimited recognitionMaturity (M)

10. 10 Risk Weight Function 0 stressloss Frequency of loss amount of loss unexpected loss Expectedloss chosen confidence level Capitalprovisions 99.9% under IRB The risk weight function is calibrated to “unexpected losses” (UL) only.

11. 11 Definition of Operational Risk Risk of loss resulting from: inadequate or failed internal processes people systems or from external events includes legal risk excludes strategic and reputational risk Includes, but not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements

12. 12 Operational Risk Events -Clients, Products & Business Practices Costs and legal liabilities associated with suitability issues, breach of fiduciary duties, sales practices, etc Hacking, branch robbery-External Fraud Front office / mid office / back office execution errors, system failures -Execution & Processing Errors Costs and legal liabilities related to workers’ wrongful dismissal, harassment, compensation, etc -Employment Practices & Workplace Safety Natural disasters and human-instigated acts of damage -Damage to Physical Assets Risk EventsExamples -Internal Fraud -Business Disruption and System Failures Software, hardware and telecommunication problems Employee robbery, misreporting positions

13. 13 Capital charge is based on the average of a fixed percentage (alpha:  ) of positive annual gross income (GI) over the previous 3 years GI: net interest income + net non-interest income as defined by national supervisors and/or national accounting standards Figures for any year in which annual gross income is negative or zero should be excluded  = 15% No qualifying criteria – encouraged to comply with sound practices paper Not expected to be used by internationally active banks or banks with significant operational risk exposures Basic Indicator Approach (BIA) Capital charge = [  (GI 1…n x  )] /n

14. 14 Basic Indicator Approach (BIA)

15. 15 Standardised Approach (TSA)

16. 16 Standardised Approach (TSA)

17. 17 AMA Qualifying Criteria Frequency of loss Amount of loss Expected loss Unexpected loss Catastrophic loss Pricing, expenses, reserves Capital Can not be absorbed by a firm

18. 18 Basel II - The four principles of Pillar 2 “Banks should have a process for assessing their overall capital adequacy in relation to their risk profile and a strategy for maintaining their capital levels” [ICAAP] Principle 1 “Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies as well as their ability to monitor and ensure their compliance with regulatory capital ratios. [SREP] Supervisors should take supervisory action if they are not satisfied with the result of this process” Principle 2 “Supervisors should expect banks to operate above the minimum regulatory capital ratios and should have the ability to require banks to hold capital in excess of the minimum” Principle 3 Principle 4 “Supervisors should seek to intervene at an early stage to prevent capital from falling below the minimum levels required to support the risk characteristics of a particular bank and should require rapid remedial action if capital is not maintained or restored”

19. 19 2 views on Pillar 2 Pillar 2 as an “add-on” to Pillar 1? Pillar 1 Pillar 2 Pillar 1 Pillar 2 as a holistic view of capital, with Pillar 1 as a sub- set?

20. 20 SREP and ICAAP components Credit risk Market risk Operational risk Settlement risk Residual risk Securitisation risk Legal and compliance risk Economic & regulatory Environment Liquidity risk IRR in non-trading activities Supervisory review process Peer group Basic risk Other risksOther considerations FairnessSupervisory action Supervisory outcomes Prudential measures Capital adjustment Provisioning Systems and controls Restriction on business Reduction of inherent risk Forward capital planning Business risks (earnings and costs Strategy Stress test Correlation and diversification Source: FSA

21. 21 Table of content Basel II overview Agenda Implications for emerging markets

22. 22 Among 115 countries, 82 non-Basel Committee member countries intend to implement Basel II, in most cases as of 2008 or 2009. Adoption of Basel II seems to be on a very fast track Financial Stability Institute survey 2006

23. 23 Moving toward Basel II adoption in the near future may not be the first priority for all non-G10 supervisory authorities. The IMF also cautions that premature adoption of Basel II in countries with limited capacity could inappropriately divert resources away from more urgent priorities, ultimately weakening rather than strengthening supervision. As Basel II is designed and calibrated accordingly to G10 countries, adoption of Basel II in many emerging markets will not be able to achieve the same set of objectives for G10 countries Moving toward Basel II adoption in the near future may not be the first priority for all non-G10 supervisory authorities. The IMF also cautions that premature adoption of Basel II in countries with limited capacity could inappropriately divert resources away from more urgent priorities, ultimately weakening rather than strengthening supervision. As Basel II is designed and calibrated accordingly to G10 countries, adoption of Basel II in many emerging markets will not be able to achieve the same set of objectives for G10 countries The FSI survey too optimistic?

24. 24 Large banks to adopt Basel II in 2010 with a phase-in period of three years, while the rest of the banking industry will follow the current capital regulation. Small and medium-sized banks, particularly foreign bank subsidiaries, have the flexibility to opt in. Large banks to adopt Basel II in 2010 with a phase-in period of three years, while the rest of the banking industry will follow the current capital regulation. Small and medium-sized banks, particularly foreign bank subsidiaries, have the flexibility to opt in. A dual-track or a bifurcated approach to Basel II China’s approach

25. 25 To introduce better corporate governance practices and to enhance risk management and internal controls. Market and official pressure for large banks to move toward Basel II for either compliance and/or competitive purposes To introduce better corporate governance practices and to enhance risk management and internal controls. Market and official pressure for large banks to move toward Basel II for either compliance and/or competitive purposes Our strategy for adopting Basel II is driven by De facto international standard for capital regulation

26. 26 Pro-cyclicality Alignment of Basel II and IFRS for provisioning Further enhancement of capital regulation in light of the sub-prime crisis Pro-cyclicality Alignment of Basel II and IFRS for provisioning Further enhancement of capital regulation in light of the sub-prime crisis Challenges Basel II implementation challenges

27. 27 Lower threshold for SMEs More conservative PD estimation A higher Beta factor to reflect the high incidence of internal fraud and the inadequacies of internal controls Lower threshold for SMEs More conservative PD estimation A higher Beta factor to reflect the high incidence of internal fraud and the inadequacies of internal controls On the technical level, changes made in light of our market conditions In search for customerization of Basel II

28. 28 Application of pillar I and pillar II IRB approach for credit risk Internal model approach for market risk Standardized approach and AMA for op risk IRB approach for credit risk Internal model approach for market risk Standardized approach and AMA for op risk Pillar I

29. 29 All large banks to have an adequate assessment process key elements of capital planning and management adequate amount of capital to provide a cushion to cover various risks. Other prudential measures that would require banks to improve their systems and controls rather than hard and fast rules that would translate the supervisory assessment process into an automatic capital add-on. All large banks to have an adequate assessment process key elements of capital planning and management adequate amount of capital to provide a cushion to cover various risks. Other prudential measures that would require banks to improve their systems and controls rather than hard and fast rules that would translate the supervisory assessment process into an automatic capital add-on. Pillar II: And pillar II

30. 30 Strengthening the risk capture of the Basel II framework (in particular for trading book and off- balance sheet exposures) Enhancing the quality of Tier 1 capital Building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen pro-cyclicality Strengthening the risk capture of the Basel II framework (in particular for trading book and off- balance sheet exposures) Enhancing the quality of Tier 1 capital Building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen pro-cyclicality Basle Committee’s comprehensiv e strategy Nov 20, 2008 Basel II: flexible and adaptable

31. 31 Building additional shock absorbers into the capital framework that can be drawn upon during periods of stress and dampen procyclicality Evaluating the need to supplement risk-based measures with simple gross measures of exposure in both prudential and risk management frameworks to help contain leverage in the banking system Strengthening supervisory frameworks to assess funding liquidity at cross-border banks Leveraging Basel II to strengthen risk management and governance practices at banks Strengthening counterparty credit risk capital, risk management and disclosure at banks Promoting globally coordinated supervisory follow-up exercises to ensure implementation of supervisory and industry sound principles Continued search for a better capital regulatory framework